The Principle of Conservatism

Question: Property and equipment is recorded at historical cost, which is subsequently depreciated over its

anticipated useful life. At some point, the asset is sold, traded, used up, or disposed of in some other manner. Land

is an exception in that it will last forever.

While in use, such assets may lose their value rather rapidly if adverse conditions arise. For example, the economy

or the environment might decline and impact the value of such assets. Increases in the fair value of property and

equipment are ignored but what about decreases?

If the value of property and equipment becomes impaired, is any accounting recognition made of that loss prior to disposal?

Is historical cost always the basis for reporting regardless of the worth of property and equipment?

For example, assume that a company constructs a plant for $3 million to manufacture widgets. However, shortly

thereafter, the global market for widgets falls precipitously so that the owner has little use for this structure. No

one wants to own a manufacturing plant for widgets. Does historical cost continue to be used in accounting for

property and equipment even if the value has been damaged significantly?

Answer: Accounting follows the principle of conservatism. Concern always arises when any property or

equipment is reported at an amount in excess of fair value. Because temporary swings in value can happen

frequently and then rebound, they do not require accounting modification. Historical cost remains the reporting

basis. Permanent declines in the worth of an asset, though, need to be noted in some appropriate manner.

Consequently, two tests have been created by FASB to determine if the value of property or equipment has been

impaired in such a serious fashion that disclosure of the damage is necessary.

If possible impairment of property or equipment is suspected, the owner estimates the total amount of cash that

will be generated by the asset during its remaining life. The resulting cash figure is then compared with the asset’s

current book value to see if it is lower. This recoverability test indicates whether a problem exists that is so

significant that immediate recognition is warranted.